McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc.

All rights reserved

CHAPTER
4
Discounted Cash Flow
Valuation
Slide 2
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Key Concepts and Skills
Be able to compute the future value and/or
present value of a single cash flow or
series of cash flows
Be able to compute the return on an
investment
Be able to use a financial calculator and/or
spreadsheet to solve time value problems
Understand perpetuities and annuities
Slide 3
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Chapter Outline
4.1 Valuation: The One-Period Case
4.2 The Multiperiod Case
4.3 Compounding Periods
4.4 Simplifications
4.5 What Is a Firm Worth?
Slide 4
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
4.1 The One-Period Case
If you were to invest $10,000 at 5-percent
interest for one year, your investment would
grow to $10,500.

$500 would be interest ($10,000 .05)
$10,000 is the principal repayment ($10,000 1)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000(1.05)

The total amount due at the end of the
investment is call the Future Value (FV).
Slide 5
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Future Value
In the one-period case, the formula for FV
can be written as:
FV = C
0
(1 + r)


Where C
0
is cash flow today (time zero), and
r is the appropriate interest rate.
Slide 6
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Present Value
If you were to be promised $10,000 due in one
year when interest rates are 5-percent, your
investment would be worth $9,523.81 in todays
dollars.
05 . 1
000 , 10 $
81 . 523 , 9 $ =
The amount that a borrower would need to set
aside today to be able to meet the promised
payment of $10,000 in one year is called the
Present Value (PV).
Note that $10,000 = $9,523.81(1.05).
Slide 7
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Present Value
In the one-period case, the formula for PV
can be written as:

r
C
PV
+
=
1
1
Where C
1
is cash flow at date 1, and
r is the appropriate interest rate.
Slide 8
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value
The Net Present Value (NPV) of an
investment is the present value of the
expected cash flows, less the cost of the
investment.
Suppose an investment that promises to
pay $10,000 in one year is offered for sale
for $9,500. Your interest rate is 5%.
Should you buy?
Slide 9
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value
81 . 23 $
81 . 523 , 9 $ 500 , 9 $
05 . 1
000 , 10 $
500 , 9 $
=
+ =
+ =
NPV
NPV
NPV
The present value of the cash inflow is greater
than the cost. In other words, the Net Present
Value is positive, so the investment should be
purchased.
Slide 10
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Net Present Value
In the one-period case, the formula for NPV can
be written as:
NPV = Cost + PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5 percent, our FV would be less
than the $10,000 the investment promised, and we
would be worse off in FV terms :

$9,500(1.05) = $9,975 < $10,000

Slide 11
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
4.2 The Multiperiod Case
The general formula for the future value of
an investment over many periods can be
written as:
FV = C
0
(1 + r)
T
Where
C
0
is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash
is invested.
Slide 12
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Future Value
Suppose a stock currently pays a
dividend of $1.10, which is expected to
grow at 40% per year for the next five
years.
What will the dividend be in five years?

FV = C
0
(1 + r)
T

$5.92 = $1.10(1.40)
5
Slide 13
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Future Value and Compounding
Notice that the dividend in year five,
$5.92, is considerably higher than the
sum of the original dividend plus five
increases of 40-percent on the original
$1.10 dividend:

$5.92 > $1.10 + 5[$1.10.40] = $3.30

This is due to compounding.
Slide 14
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Future Value and Compounding
0 1 2 3 4 5
10 . 1 $
3
) 40 . 1 ( 10 . 1 $
02 . 3 $
) 40 . 1 ( 10 . 1 $
54 . 1 $
2
) 40 . 1 ( 10 . 1 $
16 . 2 $
5
) 40 . 1 ( 10 . 1 $
92 . 5 $
4
) 40 . 1 ( 10 . 1 $
23 . 4 $
Slide 15
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Present Value and Discounting
How much would an investor have to set
aside today in order to have $20,000 five
years from now if the current rate is 15%?
0 1 2 3 4 5
$20,000 PV
5
) 15 . 1 (
000 , 20 $
53 . 943 , 9 $ =
Slide 16
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
How Long is the Wait?
If we deposit $5,000 today in an account paying
10%, how long does it take to grow to $10,000?
T
r C FV ) 1 (
0
+ =
T
) 10 . 1 ( 000 , 5 $ 000 , 10 $ =
2
000 , 5 $
000 , 10 $
) 10 . 1 ( = =
T
) 2 ln( ) 10 . 1 ln( =
T
years 27 . 7
0953 . 0
6931 . 0
) 10 . 1 ln(
) 2 ln(
= = = T
Slide 17
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Assume the total cost of a college education will be
$50,000 when your child enters college in 12 years.
You have $5,000 to invest today. What rate of
interest must you earn on your investment to cover
the cost of your childs education?
What Rate Is Enough?
T
r C FV ) 1 (
0
+ =
12
) 1 ( 000 , 5 $ 000 , 50 $ r + =
10
000 , 5 $
000 , 50 $
) 1 (
12
= = + r
12 1
10 ) 1 ( = +r
2115 . 1 2115 . 1 1 10
12 1
= = = r
About 21.15%.
Slide 18
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Calculator Keys
Texas Instruments BA-II Plus
FV = future value
PV = present value
I/Y = periodic interest rate
P/Y must equal 1 for the I/Y to be the periodic rate
Interest is entered as a percent, not a decimal
N = number of periods
Remember to clear the registers (CLR TVM)
after each problem
Other calculators are similar in format
Slide 19
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Multiple Cash Flows
Consider an investment that pays $200
one year from now, with cash flows
increasing by $200 per year through year
4. If the interest rate is 12%, what is the
present value of this stream of cash flows?
If the issuer offers this investment for
$1,500, should you purchase it?
Slide 20
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Multiple Cash Flows
0 1 2 3 4
200 400 600 800
178.57
318.88
427.07
508.41
1,432.93
Present Value < Cost Do Not Purchase
Slide 21
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Valuing Lumpy Cash Flows
First, set your calculator to 1 payment per year.
Then, use the cash flow menu:
CF2
CF1
F2
F1
CF0
1
200
1
1,432.93
0
400
I
NPV
12
CF4
CF3
F4
F3
1
600
1
800
Slide 22
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
4.3 Compounding Periods
Compounding an investment m times a
year for T years provides for future value of
wealth:
T m
m
r
C FV

|
.
|

\
|
+ = 1
0
Slide 23
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Compounding Periods
For example, if you invest $50 for 3
years at 12% compounded semi-
annually, your investment will grow to
93 . 70 $ ) 06 . 1 ( 50 $
2
12 .
1 50 $
6
3 2
= =
|
.
|

\
|
+ =

FV
Slide 24
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Effective Annual Rates of
Interest
A reasonable question to ask in the above
example is what is the effective annual
rate of interest on that investment?
The Effective Annual Rate (EAR) of interest is the
annual rate that would give us the same end-of-
investment wealth after 3 years:
93 . 70 $ ) 06 . 1 ( 50 $ )
2
12 .
1 ( 50 $
6 3 2
= = + =

FV
93 . 70 $ ) 1 ( 50 $
3
= + EAR
Slide 25
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Effective Annual Rates of
Interest
So, investing at 12.36% compounded
annually is the same as investing at 12%
compounded semi-annually.
93 . 70 $ ) 1 ( 50 $
3
= + = EAR FV
50 $
93 . 70 $
) 1 (
3
= + EAR
1236 . 1
50 $
93 . 70 $
3 1
=
|
.
|

\
|
= EAR
Slide 26
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Effective Annual Rates of Interest
Find the Effective Annual Rate (EAR) of
an 18% APR loan that is compounded
monthly.
What we have is a loan with a monthly
interest rate rate of 1%.
This is equivalent to a loan with an annual
interest rate of 19.56%.
1956 . 1 ) 015 . 1 (
12
18 .
1 1
12
12
= =
|
.
|

\
|
+ =
|
.
|

\
|
+
m n
m
r
Slide 27
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
EAR on a Financial Calculator
keys:

description:

[2nd] [ICONV]



Opens interest rate conversion menu
[] [EFF=] [CPT] 19.56

Texas Instruments BAII Plus
[][NOM=] 18 [ENTER]
Sets 18 APR.

[] [C/Y=] 12 [ENTER] Sets 12 payments per year
Slide 28
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Continuous Compounding
The general formula for the future value of an
investment compounded continuously over
many periods can be written as:
FV = C
0
e
rT
Where
C
0
is cash flow at date 0,
r is the stated annual interest rate,
T is the number of years, and
e is a transcendental number approximately
equal to 2.718. e
x
is a key on your
calculator.
Slide 29
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
4.4 Simplifications
Perpetuity
A constant stream of cash flows that lasts forever
Growing perpetuity
A stream of cash flows that grows at a constant rate
forever
Annuity
A stream of constant cash flows that lasts for a fixed
number of periods
Growing annuity
A stream of cash flows that grows at a constant rate
for a fixed number of periods
Slide 30
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuity
A constant stream of cash flows that lasts forever
0

1
C
2
C
3
C
+
+
+
+
+
+
=
3 2
) 1 ( ) 1 ( ) 1 ( r
C
r
C
r
C
PV
r
C
PV =
Slide 31
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Perpetuity: Example
What is the value of a British consol that
promises to pay 15 every year for
ever?
The interest rate is 10-percent.
0

1
15
2
15
3
15
150
10 .
15
= = PV
Slide 32
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Growing Perpetuity
A growing stream of cash flows that lasts forever
0

1
C
2
C(1+g)
3
C (1+g)
2
+
+
+
+
+
+
+
+
=
3
2
2
) 1 (
) 1 (
) 1 (
) 1 (
) 1 ( r
g C
r
g C
r
C
PV
g r
C
PV

=
Slide 33
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Growing Perpetuity: Example
The expected dividend next year is $1.30, and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of
this promised dividend stream?
0

1
$1.30
2
$1.30(1.05)
3
$1.30 (1.05)
2
00 . 26 $
05 . 10 .
30 . 1 $
=

= PV
Slide 34
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Annuity
A constant stream of cash flows with a fixed
maturity
0 1
C
2
C
3
C
T
r
C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
3 2
+
+
+
+
+
+
+
=
(

+
=
T
r r
C
PV
) 1 (
1
1
T
C

Slide 35
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Annuity: Example
If you can afford a $400 monthly car payment,
how much car can you afford if interest rates are
7% on 36-month loans?
0
1
$400
2
$400
3
$400
59 . 954 , 12 $
) 12 07 . 1 (
1
1
12 / 07 .
400 $
36
=
(

+
= PV
36
$400

Slide 36
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
What is the present value of a four-year annuity of
$100 per year that makes its first payment two years from
today if the discount rate is 9%?



22 . 297 $
09 . 1
97 . 327 $
0
= = PV
0 1 2 3 4 5
$100 $100 $100 $100 $323.97 $297.22
97 . 323 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
) 09 . 1 (
100 $
4 3 2 1
4
1
1
= + + + = =

= t
t
PV
Slide 37
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Growing Annuity
A growing stream of cash flows with a fixed
maturity
0 1
C
T
T
r
g C
r
g C
r
C
PV
) 1 (
) 1 (
) 1 (
) 1 (
) 1 (
1
2
+
+
+ +
+
+
+
+
=

(
(

|
|
.
|

\
|
+
+

=
T
r
g
g r
C
PV
) 1 (
1
1

2
C(1+g)
3
C (1+g)
2
T
C(1+g)
T-1
Slide 38
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Growing Annuity: Example
A defined-benefit retirement plan offers to pay $20,000
per year for 40 years and increase the annual payment by
3% each year. What is the present value at retirement if
the discount rate is 10%?
0 1
$20,000
57 . 121 , 265 $
10 . 1
03 . 1
1
03 . 10 .
000 , 20 $
40
=
(
(

|
.
|

\
|

= PV

2
$20,000(1.03)
40
$20,000(1.03)
39
Slide 39
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Growing Annuity: Example
You are evaluating an income generating property. Net rent is
received at the end of each year. The first year's rent is
expected to be $8,500, and rent is expected to increase 7%
each year. What is the present value of the estimated income
stream over the first 5 years if the discount rate is 12%?


0 1 2 3 4 5
500 , 8 $
= ) 07 . 1 ( 500 , 8 $
=
2
) 07 . 1 ( 500 , 8 $
095 , 9 $
65 . 731 , 9 $
=
3
) 07 . 1 ( 500 , 8 $
87 . 412 , 10 $
=
4
) 07 . 1 ( 500 , 8 $
77 . 141 , 11 $
$34,706.26
Slide 40
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
4.5 What Is a Firm Worth?
Conceptually, a firm should be worth the
present value of the firms cash flows.
The tricky part is determining the size,
timing, and risk of those cash flows.
Slide 41
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin
Quick Quiz
How is the future value of a single cash flow
computed?
How is the present value of a series of cash
flows computed.
What is the Net Present Value of an
investment?
What is an EAR, and how is it computed?
What is a perpetuity? An annuity?